Aggregate Demand and its Components

In Chapter 2, Macroeconomics, National Income Accounting, we had learnt a few terms in an economy (Gross Domestic Product: GDP) like:

  • Consumption
  • Investment or the total output of final commodities and services

These terms have dual associations. In Chapter 2, these terms were used in the accounting sense, indicating actual values of these items as measured by the pursuits within the economy in a certain year. 

These terminologies, however, can be used with a different association. Consumption may indicate not what people have actually utilised in a year, but what they had planned to utilise during the same period. Similarly, investment means the amount a manufacturer plans to add to their catalogue (inventory).

It may be distinct from what they end up doing. Suppose a manufacturer plans to add 1,000 worth of commodities to their stockpile by the end of the year. The planned investment is 1,000 in that year. However, due to an unpredicted increase of demand for the commodities in the market, the volume of the sales shoots up from what they had outlined to sell.

To meet this extra surplus demand, they have to sell commodities worth 300 from their stockpile. Hence, at the end of the year, their catalogue increases by (1,000 – 300) = 700. Their outlined investment is 1,000, whereas the actual or ex-post investment would be 700 only. We call the outlined values of the variables: utilisation, investment, or output of final commodities their ex-post measures.

In simple words, ex-ante portrays what has been outlined, and ex-post portrays what has actually happened. In order to comprehend the determination of earning, we need to know the outlined values of distinct components of the average demand.

5⁠–6 Marks Questions
Q.1 Explain the meaning and components of aggregate demand.
Answer:
(a) Meaning Aggregated demand means the total demand for final goods and services in an economy.

It is the total (final) expenditure of all the units of the economy, i.e., households, firms, government, and the rest of the world.

(b) Following are the various components of aggregate demand:
Components of aggregate demand AD = C + I + G + (X – M)
(a) Private (Household consumption expenditure) (C)) It comprises a household’s expenditure on the consumption of goods and services.

These goods can be durable, semi-durable, or non-durable.

Consumption of households depends upon their disposable income and MPC.

(b) Investment expenditure (I)) It refers to the expenditure incurred by firms on the purchase of capital goods like machines, plants, equipment, etc., to increase the production capacity.

 Investment decision depends upon the relative values of MEI (Rate of return/Marginal efficiency of investment) and rate of interest.

(c) Government expenditure (G)) It refers to expenditure incurred by the government on the purchase of consumer goods and capital goods to satisfy the collective wants of the society. Example: public parks, public hospitals, roads, etc.

Government expenditure depends upon the priorities of the government.

(d) Net exports

(X – M)

It is the difference between exports and imports.

It reflects the net demand for a domestic product by the rest of the world.

Net exports depend upon many things like foreign trade policy, foreign exchange rate, comparative prices,  quality, etc.

 

Q.2 Explain aggregate demand with the help of a hypothetical schedule.
(a) Meaning Aggregate demand means the total demand for final goods and services in an economy.

It is the total (final) expenditure of all the units of an economy, i.e., households, firms, government, and the rest of the world.

However, in case of a two sector model, we only consider the consumption expenditure of households and investment expenditure of firms.

(b) Hypothetical schedule Income (Y)

(in crore)

Consumption (C)

(in crore)

Investments (I)

(in crore)

AD = C + I

(in crore)

0 40 20 60
100 120 20 140
200 200 20 220
300 280 20 300
400 360 20 380
(c) Explanation In the given schedule, it can be observed that:

Even at zero levels of income, consumption of `40 crore and investment of `20 crore prevail which are autonomous consumption and autonomous investment. AD is a sum of consumption and investment which is `60 crore.

Every time with the increase in income by `100 crores, the consumption is also increasing by `80 crore but investment being autonomous remains the same at all the levels of income. AD, which is the sum of C and I, also changes but after zero levels, it fully depends upon the consumption expenditure.

So, with an increase in income, AD also increases, but the rate of increase in AD is less than the rate of increase in income.

The above-mentioned is the concept that is explained in detail about aggregate demand and its components. To know more, stay tuned to BYJUS.

 

1 Comment

  1. Byju’s helps me to get answer as I can understand. Thank you

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